The majority of the time, targeting higher returns is done through investing in several assets. However, by buying more than one stock or bond, an investor is starting to diversify a portfolio while still seeking high returns. A fully diversified portfolio is another aim of many fund managers. But why? Here, we look at what a diversified portfolio is so you can ensure your portfolio achieves it - should you want to!
Diversified portfolio definition
A diversified portfolio is a selection of investments made by one fund or investor. When a portfolio is fully diversified, not only are returns maximised, but risk is materially diminished too.
Why diversify a portfolio?
Diversifying a portfolio to maximise returns and reduce risk exposure may sound like a lot of investment speak and jargon. But if you think about it logically, by buying even two different stocks, you are minimising the risk you are taking on. By not 'putting all your eggs in one basket', you reduce your exposure to one company. For example, what would happen if you only made one investment, and that company went bankrupt? You are likely to lose all your money. By putting your money into different investments, you reduce the chances of suffering a material loss.
Importantly, a diversified portfolio will also invest in different asset classes and sectors. The reason being is that different asset classes and sectors behave differently and separately from one another. That means, for example, if one part of the FTSE100 has a catastrophic fall on one day, your bonds or alternative investments will not. You protect your downside as a result and therefore reduce the losses you may otherwise have made. On the flip side, it also means you can benefit from returns from a range of investments. On days that one of your investments has a good day, so do you. Then, on the days another one of your investments has a good day, you also do, again!
How to diversify your portfolio
It is very well knowing why you need to diversify your portfolio, yet you still need to know how to go about it. Doing so will help you diversify your portfolio to its fullest potential.
Select a range of asset classes
As briefly mentioned earlier, it is crucial to invest in a range of asset classes if you are looking to diversify a portfolio fully. The reason being is that assets react to market movements in different amounts - and sometimes different directions. Asset classes can be strongly correlated or weakly correlated. However, they can also be positively correlated or negatively correlated. By investing across a broad spectrum of investments, you are making the most of such correlations to reduce risk.
Select a range of sectors
While asset classes can move very differently in terms of returns, so can sectors. Therefore, it is highly beneficial to invest in a range of sectors within an asset class if you can. For instance, look at the past year during Covid-19 restrictions. The oil industry had an absolute shocker, losing a great deal of value. On the flip side, tech stocks fared the storm well and created healthy returns. Investing in a range of sectors can consequently protect against such falls.
If possible, it is good to invest consistently too. The reason being is that you are helping spread the times you enter the market. As a result, you balance out times you invest when markets are high with investing at times when markets are low. Your returns can vary greatly depending on when you invest - even if you invest in the same stock. Therefore, making regular investments is an excellent strategy to follow, as so many investors enter the market when prices of particular stocks have seen good returns. Stocks are therefore priced relatively high. However, if you invest consistently, you minimise the number of shares you buy when prices are up and buy more when they are lower.
Know the fees you are incurring
It can be easy to go on headline returns of your assets when calculating how successful your investments have been. However, investments are subject to many fees. Make sure you know about all costs you are incurring. Some platforms charge more for certain types of investing, while others reward greater trading amounts. Fees can materially eat into any returns you make - regardless of how well your portfolio has been diversified or structured. Make sure you are optimising your returns by keeping fees the best possible value. Sometimes the cheapest will not always be the best as trading platforms or investment managers may hide fees elsewhere in your trading transactions.
Consider passive investing
If you are unsure about how to diversify a portfolio optimally, it can be a good idea to consider passive investing. More specifically, passive investing in a range of funds. Consider fixed income funds and alternative investments. Such investments include commodities and real estate investment trusts. Passive investing in this way is investing in an already diversified range within an asset class. By passively investing in several asset classes, you are further diversifying your portfolio.
Diversifying your portfolio
Diversifying your portfolio is good for two key reasons. Firstly, you can help increase the returns you see by investing in many companies or assets that have the potential to increase in value. Secondly, you reduce your exposure to losses. As a result, it is not only highly beneficial; it is also highly recommended by many financial advisors.